ICAI Notes- Unit 2: Determination of Prices | Business Economics for CA Foundation PDF Download

 Page 1


  
 
 
BUSINESS ECONOMICS  
 4.16 
 
 
LEARNING OUTCOMES 
UNIT - 2: DETERMINATION OF 
PRICES 
 
 
 
After studying this unit, you would be able to:  
? Explain how the prices are generally determined. 
? Describe how changes in demand and supply affect prices and 
quantities demanded and supplied. 
 
2.0  INTRODUCTION 
Prices of goods express their exchange value. Prices are also used for expressing the value of 
various services rendered by different factors of production such as land, labour, capital and 
organization in the form of rent, wages, interest and profit respectively. Therefore, the 
concept of price, especially the process of price determination, is of vital importance in 
Economics. 
In this unit, we shall learn how demand and supply interact to strike a balance so that 
equilibrium price is determined in a free market. A free market is one in which the forces of 
demand and supply are free to take their own course and there is no intervention from 
outside by government or any other entity. It is to be noted that, generally, it is the 
interaction between demand and supply that determines the price, but sometimes 
Government intervenes and determines the price either fully or partially. For example, the 
Government of India fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are 
critical inputs. It also fixes the procurement prices of wheat, rice, sugarcane, etc. in order to 
protect the interests of both producers and consumers. While determining these prices, the 
Government takes into account factors like cost of inputs, risks of business, nature of the 
product etc. 
© The Institute of Chartered Accountants of India
Page 2


  
 
 
BUSINESS ECONOMICS  
 4.16 
 
 
LEARNING OUTCOMES 
UNIT - 2: DETERMINATION OF 
PRICES 
 
 
 
After studying this unit, you would be able to:  
? Explain how the prices are generally determined. 
? Describe how changes in demand and supply affect prices and 
quantities demanded and supplied. 
 
2.0  INTRODUCTION 
Prices of goods express their exchange value. Prices are also used for expressing the value of 
various services rendered by different factors of production such as land, labour, capital and 
organization in the form of rent, wages, interest and profit respectively. Therefore, the 
concept of price, especially the process of price determination, is of vital importance in 
Economics. 
In this unit, we shall learn how demand and supply interact to strike a balance so that 
equilibrium price is determined in a free market. A free market is one in which the forces of 
demand and supply are free to take their own course and there is no intervention from 
outside by government or any other entity. It is to be noted that, generally, it is the 
interaction between demand and supply that determines the price, but sometimes 
Government intervenes and determines the price either fully or partially. For example, the 
Government of India fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are 
critical inputs. It also fixes the procurement prices of wheat, rice, sugarcane, etc. in order to 
protect the interests of both producers and consumers. While determining these prices, the 
Government takes into account factors like cost of inputs, risks of business, nature of the 
product etc. 
© The Institute of Chartered Accountants of India
 
 
  PRICE DETERMINATION IN DIFFERENT MARKETS 
 
 
4.17 
One of the main reasons for studying the demand and supply model is that the model is 
particularly useful in explaining how markets work. A comprehensive knowledge of the 
movements of these market forces enables us to explain the observed changes in 
equilibrium prices and quantities of all types of products and factors. We will be able to 
anticipate the possible market outcomes in real markets by applying the principles 
underlying the interactions of demand and supply. Business firms can use the model of 
demand and supply to predict the probable effects of various economic as well as non-
economic factors on equilibrium prices and quantities. For example, the market outcomes of 
government intervention in the form of taxation, subsidies, price ceiling and floor prices etc. 
can be analysed with the help of equilibrium analysis. 
2.1  DETERMINATION OF PRICES - A GENERAL VIEW 
In an open competitive market, it is the interaction between demand and supply that tends 
to determine equilibrium price and quantity. In the context of market analysis, the term 
equilibrium refers to a state of market in which the quantity demanded of a commodity 
equals the quantity supplied of the commodity. In an equilibrium state, the aggregate 
quantity that all firms wish to sell equals the total quantity that all buyers in the market wish 
to buy and therefore, the market clears. Equilibrium price or market clearing price is the 
price at which the quantity demanded of a commodity equals the quantity supplied of the 
commodity i.e. at this price there is no unsold stock or no unsupplied demand. 
To analyse how equilibrium price is determined in a market, we need to bring together 
demand for and supply of the commodity in the market, for this we have the following 
schedule: 
Table – 3: Determination of Price 
S. No. Price (
`
) Demand Units Supply (Units) 
1 1 60 5 
2 2 35 35 
3 3 20 45 
4 4 15 55 
5 5 10 65 
When we plot the above points on a single graph with price on Y-axis and quantity 
demanded and supplied on X-axis, we get a figure as shown below: 
© The Institute of Chartered Accountants of India
Page 3


  
 
 
BUSINESS ECONOMICS  
 4.16 
 
 
LEARNING OUTCOMES 
UNIT - 2: DETERMINATION OF 
PRICES 
 
 
 
After studying this unit, you would be able to:  
? Explain how the prices are generally determined. 
? Describe how changes in demand and supply affect prices and 
quantities demanded and supplied. 
 
2.0  INTRODUCTION 
Prices of goods express their exchange value. Prices are also used for expressing the value of 
various services rendered by different factors of production such as land, labour, capital and 
organization in the form of rent, wages, interest and profit respectively. Therefore, the 
concept of price, especially the process of price determination, is of vital importance in 
Economics. 
In this unit, we shall learn how demand and supply interact to strike a balance so that 
equilibrium price is determined in a free market. A free market is one in which the forces of 
demand and supply are free to take their own course and there is no intervention from 
outside by government or any other entity. It is to be noted that, generally, it is the 
interaction between demand and supply that determines the price, but sometimes 
Government intervenes and determines the price either fully or partially. For example, the 
Government of India fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are 
critical inputs. It also fixes the procurement prices of wheat, rice, sugarcane, etc. in order to 
protect the interests of both producers and consumers. While determining these prices, the 
Government takes into account factors like cost of inputs, risks of business, nature of the 
product etc. 
© The Institute of Chartered Accountants of India
 
 
  PRICE DETERMINATION IN DIFFERENT MARKETS 
 
 
4.17 
One of the main reasons for studying the demand and supply model is that the model is 
particularly useful in explaining how markets work. A comprehensive knowledge of the 
movements of these market forces enables us to explain the observed changes in 
equilibrium prices and quantities of all types of products and factors. We will be able to 
anticipate the possible market outcomes in real markets by applying the principles 
underlying the interactions of demand and supply. Business firms can use the model of 
demand and supply to predict the probable effects of various economic as well as non-
economic factors on equilibrium prices and quantities. For example, the market outcomes of 
government intervention in the form of taxation, subsidies, price ceiling and floor prices etc. 
can be analysed with the help of equilibrium analysis. 
2.1  DETERMINATION OF PRICES - A GENERAL VIEW 
In an open competitive market, it is the interaction between demand and supply that tends 
to determine equilibrium price and quantity. In the context of market analysis, the term 
equilibrium refers to a state of market in which the quantity demanded of a commodity 
equals the quantity supplied of the commodity. In an equilibrium state, the aggregate 
quantity that all firms wish to sell equals the total quantity that all buyers in the market wish 
to buy and therefore, the market clears. Equilibrium price or market clearing price is the 
price at which the quantity demanded of a commodity equals the quantity supplied of the 
commodity i.e. at this price there is no unsold stock or no unsupplied demand. 
To analyse how equilibrium price is determined in a market, we need to bring together 
demand for and supply of the commodity in the market, for this we have the following 
schedule: 
Table – 3: Determination of Price 
S. No. Price (
`
) Demand Units Supply (Units) 
1 1 60 5 
2 2 35 35 
3 3 20 45 
4 4 15 55 
5 5 10 65 
When we plot the above points on a single graph with price on Y-axis and quantity 
demanded and supplied on X-axis, we get a figure as shown below: 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 4.18 
 
Fig. 6: Determination of Equilibrium Price 
It is easy to see what will be the market price of the article. It cannot be ` 1, because at that 
price there would be 60 units in demand, but only 5 units on offer. Competition among 
buyers would force the price up. On the other hand, it cannot ` 5, for at that price, there 
would be 65 units on offer for sale but only 10 units in demand. Competition among sellers 
would force the price down. At ` 2, demand and supply are equal (35 units) and the market 
price will tend to settle at this figure. This is equilibrium price and quantity – the point at 
which price and output will tend to stay. Once this point is reached, we will have stable 
equilibrium. Equilibrium is said to be stable if any disturbance to it is self-adjusting so that 
the original equilibrium is restored. In other words, if the equilibrium be disrupted, the 
market returns to equilibrium. It should be noted that it would be stable only if other things 
are equal. 
Figure 7 will demonstrate how stable equilibrium is achieved through price mechanism or 
market mechanism. If the market price is above the equilibrium price, say ` 15, the market 
supply is greater than market demand and there is an excess supply or surplus in the 
market. Competing sellers will lower prices in order to clear their unsold stock. As we know, 
other things remaining constant, as price falls quantity demanded rises and quantity supplied 
falls. In this process the supply-demand gap is reduced and eventually eliminated thus 
restoring equilibrium. 
 
Fig 7: Stable Equilibrium 
Likewise, if the prevailing market price is below equilibrium, say ` 5 in our example, a 
shortage arises as quantity demanded exceeds the quantity supplied. The shortage prompts 
© The Institute of Chartered Accountants of India
Page 4


  
 
 
BUSINESS ECONOMICS  
 4.16 
 
 
LEARNING OUTCOMES 
UNIT - 2: DETERMINATION OF 
PRICES 
 
 
 
After studying this unit, you would be able to:  
? Explain how the prices are generally determined. 
? Describe how changes in demand and supply affect prices and 
quantities demanded and supplied. 
 
2.0  INTRODUCTION 
Prices of goods express their exchange value. Prices are also used for expressing the value of 
various services rendered by different factors of production such as land, labour, capital and 
organization in the form of rent, wages, interest and profit respectively. Therefore, the 
concept of price, especially the process of price determination, is of vital importance in 
Economics. 
In this unit, we shall learn how demand and supply interact to strike a balance so that 
equilibrium price is determined in a free market. A free market is one in which the forces of 
demand and supply are free to take their own course and there is no intervention from 
outside by government or any other entity. It is to be noted that, generally, it is the 
interaction between demand and supply that determines the price, but sometimes 
Government intervenes and determines the price either fully or partially. For example, the 
Government of India fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are 
critical inputs. It also fixes the procurement prices of wheat, rice, sugarcane, etc. in order to 
protect the interests of both producers and consumers. While determining these prices, the 
Government takes into account factors like cost of inputs, risks of business, nature of the 
product etc. 
© The Institute of Chartered Accountants of India
 
 
  PRICE DETERMINATION IN DIFFERENT MARKETS 
 
 
4.17 
One of the main reasons for studying the demand and supply model is that the model is 
particularly useful in explaining how markets work. A comprehensive knowledge of the 
movements of these market forces enables us to explain the observed changes in 
equilibrium prices and quantities of all types of products and factors. We will be able to 
anticipate the possible market outcomes in real markets by applying the principles 
underlying the interactions of demand and supply. Business firms can use the model of 
demand and supply to predict the probable effects of various economic as well as non-
economic factors on equilibrium prices and quantities. For example, the market outcomes of 
government intervention in the form of taxation, subsidies, price ceiling and floor prices etc. 
can be analysed with the help of equilibrium analysis. 
2.1  DETERMINATION OF PRICES - A GENERAL VIEW 
In an open competitive market, it is the interaction between demand and supply that tends 
to determine equilibrium price and quantity. In the context of market analysis, the term 
equilibrium refers to a state of market in which the quantity demanded of a commodity 
equals the quantity supplied of the commodity. In an equilibrium state, the aggregate 
quantity that all firms wish to sell equals the total quantity that all buyers in the market wish 
to buy and therefore, the market clears. Equilibrium price or market clearing price is the 
price at which the quantity demanded of a commodity equals the quantity supplied of the 
commodity i.e. at this price there is no unsold stock or no unsupplied demand. 
To analyse how equilibrium price is determined in a market, we need to bring together 
demand for and supply of the commodity in the market, for this we have the following 
schedule: 
Table – 3: Determination of Price 
S. No. Price (
`
) Demand Units Supply (Units) 
1 1 60 5 
2 2 35 35 
3 3 20 45 
4 4 15 55 
5 5 10 65 
When we plot the above points on a single graph with price on Y-axis and quantity 
demanded and supplied on X-axis, we get a figure as shown below: 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 4.18 
 
Fig. 6: Determination of Equilibrium Price 
It is easy to see what will be the market price of the article. It cannot be ` 1, because at that 
price there would be 60 units in demand, but only 5 units on offer. Competition among 
buyers would force the price up. On the other hand, it cannot ` 5, for at that price, there 
would be 65 units on offer for sale but only 10 units in demand. Competition among sellers 
would force the price down. At ` 2, demand and supply are equal (35 units) and the market 
price will tend to settle at this figure. This is equilibrium price and quantity – the point at 
which price and output will tend to stay. Once this point is reached, we will have stable 
equilibrium. Equilibrium is said to be stable if any disturbance to it is self-adjusting so that 
the original equilibrium is restored. In other words, if the equilibrium be disrupted, the 
market returns to equilibrium. It should be noted that it would be stable only if other things 
are equal. 
Figure 7 will demonstrate how stable equilibrium is achieved through price mechanism or 
market mechanism. If the market price is above the equilibrium price, say ` 15, the market 
supply is greater than market demand and there is an excess supply or surplus in the 
market. Competing sellers will lower prices in order to clear their unsold stock. As we know, 
other things remaining constant, as price falls quantity demanded rises and quantity supplied 
falls. In this process the supply-demand gap is reduced and eventually eliminated thus 
restoring equilibrium. 
 
Fig 7: Stable Equilibrium 
Likewise, if the prevailing market price is below equilibrium, say ` 5 in our example, a 
shortage arises as quantity demanded exceeds the quantity supplied. The shortage prompts 
© The Institute of Chartered Accountants of India
 
 
  PRICE DETERMINATION IN DIFFERENT MARKETS 
 
 
4.19 
the price to rise, as the buyers, who are unable to obtain as much of the good as they desire, 
bid the price higher. The market price tends to increase. Other things remaining the same, 
the price rise causes a decrease in the quantity demanded by the buyers and an increase in 
the quantity supplied by the sellers and vice versa. This process will continue as long as 
demand exceeds supply. The market thus achieves a state where the quantity that firms sell 
is equal to the quantity that the consumers desire to buy. At equilibrium price ( ` 10), the 
supply decisions of the firms tend to match the demand decisions of the buyers. Thus, the 
equilibrium is restored automatically, through the fundamental working of the market and 
price movements eliminate shortage or surplus. 
2.2 CHANGES IN DEMAND AND SUPPLY 
The above analysis of market equilibrium was done by us under the ceteris paribus 
assumption. The facts of the real world, however, are such that the determinants of demand 
other than price of the commodity under consideration (like income, tastes and preferences, 
population, technology, prices of factors of production etc.) always change causing shifts in 
demand and supply. Such shifts affect equilibrium price and quantity. The four possible 
changes in demand and supply are: 
(i) An increase (shift to the right) in demand; 
(ii) A decrease (shift to the left) in demand; 
(iii) An increase (shift to the right) in supply; 
(iv) A decrease (shift to the left) in supply. 
We will consider each of the above changes one by one. 
(i)  An increase in demand: In figure 8, the original demand curve of a normal good is 
DD and supply curve is SS. At equilibrium price OP, demand and supply are equal to OQ. 
Now suppose the money income of the consumer increases and the demand curve shifts to 
D
1
D
1
 and the supply curve remains the same. We will see that on the new demand curve 
D 1D 1 at OP price, demand increases to OQ 2 while supply remains the same i.e. OQ and there 
is excess demand in the market equal to Q Q 2. Since supply is short of demand, price will go 
up to OP 1. With the higher price, supply will also shoot up generating an increase in the 
quantity supplied or an upward movement along the supply curve. Ultimately, a new 
equilibrium between demand and supply will be reached. At this equilibrium point, OP 1 is 
the price and OQ
1
 is the quantity which is demanded and supplied.  
© The Institute of Chartered Accountants of India
Page 5


  
 
 
BUSINESS ECONOMICS  
 4.16 
 
 
LEARNING OUTCOMES 
UNIT - 2: DETERMINATION OF 
PRICES 
 
 
 
After studying this unit, you would be able to:  
? Explain how the prices are generally determined. 
? Describe how changes in demand and supply affect prices and 
quantities demanded and supplied. 
 
2.0  INTRODUCTION 
Prices of goods express their exchange value. Prices are also used for expressing the value of 
various services rendered by different factors of production such as land, labour, capital and 
organization in the form of rent, wages, interest and profit respectively. Therefore, the 
concept of price, especially the process of price determination, is of vital importance in 
Economics. 
In this unit, we shall learn how demand and supply interact to strike a balance so that 
equilibrium price is determined in a free market. A free market is one in which the forces of 
demand and supply are free to take their own course and there is no intervention from 
outside by government or any other entity. It is to be noted that, generally, it is the 
interaction between demand and supply that determines the price, but sometimes 
Government intervenes and determines the price either fully or partially. For example, the 
Government of India fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are 
critical inputs. It also fixes the procurement prices of wheat, rice, sugarcane, etc. in order to 
protect the interests of both producers and consumers. While determining these prices, the 
Government takes into account factors like cost of inputs, risks of business, nature of the 
product etc. 
© The Institute of Chartered Accountants of India
 
 
  PRICE DETERMINATION IN DIFFERENT MARKETS 
 
 
4.17 
One of the main reasons for studying the demand and supply model is that the model is 
particularly useful in explaining how markets work. A comprehensive knowledge of the 
movements of these market forces enables us to explain the observed changes in 
equilibrium prices and quantities of all types of products and factors. We will be able to 
anticipate the possible market outcomes in real markets by applying the principles 
underlying the interactions of demand and supply. Business firms can use the model of 
demand and supply to predict the probable effects of various economic as well as non-
economic factors on equilibrium prices and quantities. For example, the market outcomes of 
government intervention in the form of taxation, subsidies, price ceiling and floor prices etc. 
can be analysed with the help of equilibrium analysis. 
2.1  DETERMINATION OF PRICES - A GENERAL VIEW 
In an open competitive market, it is the interaction between demand and supply that tends 
to determine equilibrium price and quantity. In the context of market analysis, the term 
equilibrium refers to a state of market in which the quantity demanded of a commodity 
equals the quantity supplied of the commodity. In an equilibrium state, the aggregate 
quantity that all firms wish to sell equals the total quantity that all buyers in the market wish 
to buy and therefore, the market clears. Equilibrium price or market clearing price is the 
price at which the quantity demanded of a commodity equals the quantity supplied of the 
commodity i.e. at this price there is no unsold stock or no unsupplied demand. 
To analyse how equilibrium price is determined in a market, we need to bring together 
demand for and supply of the commodity in the market, for this we have the following 
schedule: 
Table – 3: Determination of Price 
S. No. Price (
`
) Demand Units Supply (Units) 
1 1 60 5 
2 2 35 35 
3 3 20 45 
4 4 15 55 
5 5 10 65 
When we plot the above points on a single graph with price on Y-axis and quantity 
demanded and supplied on X-axis, we get a figure as shown below: 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 4.18 
 
Fig. 6: Determination of Equilibrium Price 
It is easy to see what will be the market price of the article. It cannot be ` 1, because at that 
price there would be 60 units in demand, but only 5 units on offer. Competition among 
buyers would force the price up. On the other hand, it cannot ` 5, for at that price, there 
would be 65 units on offer for sale but only 10 units in demand. Competition among sellers 
would force the price down. At ` 2, demand and supply are equal (35 units) and the market 
price will tend to settle at this figure. This is equilibrium price and quantity – the point at 
which price and output will tend to stay. Once this point is reached, we will have stable 
equilibrium. Equilibrium is said to be stable if any disturbance to it is self-adjusting so that 
the original equilibrium is restored. In other words, if the equilibrium be disrupted, the 
market returns to equilibrium. It should be noted that it would be stable only if other things 
are equal. 
Figure 7 will demonstrate how stable equilibrium is achieved through price mechanism or 
market mechanism. If the market price is above the equilibrium price, say ` 15, the market 
supply is greater than market demand and there is an excess supply or surplus in the 
market. Competing sellers will lower prices in order to clear their unsold stock. As we know, 
other things remaining constant, as price falls quantity demanded rises and quantity supplied 
falls. In this process the supply-demand gap is reduced and eventually eliminated thus 
restoring equilibrium. 
 
Fig 7: Stable Equilibrium 
Likewise, if the prevailing market price is below equilibrium, say ` 5 in our example, a 
shortage arises as quantity demanded exceeds the quantity supplied. The shortage prompts 
© The Institute of Chartered Accountants of India
 
 
  PRICE DETERMINATION IN DIFFERENT MARKETS 
 
 
4.19 
the price to rise, as the buyers, who are unable to obtain as much of the good as they desire, 
bid the price higher. The market price tends to increase. Other things remaining the same, 
the price rise causes a decrease in the quantity demanded by the buyers and an increase in 
the quantity supplied by the sellers and vice versa. This process will continue as long as 
demand exceeds supply. The market thus achieves a state where the quantity that firms sell 
is equal to the quantity that the consumers desire to buy. At equilibrium price ( ` 10), the 
supply decisions of the firms tend to match the demand decisions of the buyers. Thus, the 
equilibrium is restored automatically, through the fundamental working of the market and 
price movements eliminate shortage or surplus. 
2.2 CHANGES IN DEMAND AND SUPPLY 
The above analysis of market equilibrium was done by us under the ceteris paribus 
assumption. The facts of the real world, however, are such that the determinants of demand 
other than price of the commodity under consideration (like income, tastes and preferences, 
population, technology, prices of factors of production etc.) always change causing shifts in 
demand and supply. Such shifts affect equilibrium price and quantity. The four possible 
changes in demand and supply are: 
(i) An increase (shift to the right) in demand; 
(ii) A decrease (shift to the left) in demand; 
(iii) An increase (shift to the right) in supply; 
(iv) A decrease (shift to the left) in supply. 
We will consider each of the above changes one by one. 
(i)  An increase in demand: In figure 8, the original demand curve of a normal good is 
DD and supply curve is SS. At equilibrium price OP, demand and supply are equal to OQ. 
Now suppose the money income of the consumer increases and the demand curve shifts to 
D
1
D
1
 and the supply curve remains the same. We will see that on the new demand curve 
D 1D 1 at OP price, demand increases to OQ 2 while supply remains the same i.e. OQ and there 
is excess demand in the market equal to Q Q 2. Since supply is short of demand, price will go 
up to OP 1. With the higher price, supply will also shoot up generating an increase in the 
quantity supplied or an upward movement along the supply curve. Ultimately, a new 
equilibrium between demand and supply will be reached. At this equilibrium point, OP 1 is 
the price and OQ
1
 is the quantity which is demanded and supplied.  
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 4.20 
 
Fig. 8: Increase in Demand, causing an increase in equilibrium price and quantity 
Thus, we see that, with an increase in demand, there is an increase in equilibrium price, as a 
result of which the quantity supplied rises. As such, the quantity sold and purchased also 
increases. 
(ii)  Decrease in Demand: The opposite will happen when demand falls as a result of a 
fall in income, while the supply remains the same. The demand curve will shift to the left and 
become D
1
D
1
 while the supply curve remains as it is. With the new demand curve D
1
D
1
, at 
original price OP, OQ
2
 is demanded and OQ is supplied. As the supply exceeds demand, 
price will come down and quantity demanded will go up. A new equilibrium price OP
1
 will 
be settled in the market where demand OQ
1
 will be equal to supply OQ
1
. 
 
Fig. 9: Decrease in Demand Resulting in a Decrease in Price and Quantity Demanded 
Thus, with a decrease in demand, there is a decrease in the equilibrium price and quantity 
demanded and supplied. 
(iii)  Increase in Supply: Let us now assume that demand does not change, but there is 
an increase in supply say, because of improved technology. 
 
Fig. 10: Increase in Supply, Resulting In Decrease in Equilibrium 
Price and Increase in Quantity Supplied 
© The Institute of Chartered Accountants of India